Fundamentals Have Went out The door
If you have been following the equities market in the past few months, you probably have seen this face melting rally that came off one of the hardest sell offs and shortest bear markets (more on this later) in history. The S&P 500, Nasdaq, and The Dow Jones Industrial Average have all rallied over 20% from their lows set on December 24th and 26th of 2018. Yet many companies have cut guidance this year, most notably Apple, the first trillion dollar company. Apple did something that should scare off anyone from holding/buying the stock, they announced in their Q4 2018 that they would discontinue sharing iPhone sales numbers (also iPads & Macs) , their flagship product which they get +50% of their revenue from. That would be like Ford Motor Company saying they are going to stop reporting truck sales. There is only one reason you do this, sales are dwindling in the new iPhone X’s. Why, because between the iPhone 7, 8, and X there really isn’t much difference to justify upgrading. Sure the X comes with face lock ID, better display, and a better camera, but does that justify shelling over +$1,000. In my opinion it does not, that is the cost of a decent laptop there. At some point people are going to realize they don’t need to upgrade their phone every year. The chart below reiterates the title of this article completely, fundamentals no longer drive these markets, so when we do revert, things will get very ugly quickly.
The S&P 500 currently sits a mere 35 points or just over 1% from setting a record all time high. But does it really mean anything considering inflation, low interest rates, and share buybacks? Those factors alone have propelled this market on this long journey that started in early 2009. Another issue to mount on top of all this the real vs nominal value of the dollar. Sure we know $1 = $1. But do we really know what it’s worth? The dollar has lost roughly 75% of it’s value against gold since 2001, that shiny rock that central banks have been stacking at a furious rate since the Global Financial Crisis (GFC.) Governments added over 651.5 tons of gold to their bags in 2018, a 74% increase over 2017. Central banks have had their biggest buying spree of gold since 1971 when the U.S. under President Richard Nixon and Secretary of State Henry Kissinger delinked the dollar from gold due to rising cost of Johnson’s Great Society and the cost of the Vietnam War.
There are a lot of factors that have gotten us to where we are today from the lows of the GFC where the whole system fell apart only to be saved by trillions of dollars injected by central banks. Those factors are: Quantitative Easing (QE), low/negative interest rates, and share buybacks.
Quantitative Easing
QE is the fancy term for inflating the money supply. Central banks do this by buying assets. The Federal Reserve (FED) buys treasuries and mortgage backed securities (MBS) from banks thus giving banks money while simultaneously suppressing interest rates via buying treasuries (will cover this more in depth under interest rates.) QE via the FED was supposed to stop after the first one, but it continued to QE 3 to keep markets in this new normal risk free environment. There is no such thing as risk free, sure central banks maybe able to prop markets up for longer, but eventually the wheels fall off the wagon. The FED’s balance sheet was ~$800 billion prior to the GFC and at the peak it reach $4.5 trillion.
There is significant correlation between the FED beginning Quantitative Tightening (QT) and the U.S. equities market struggling and chopping since the beginning of 2018. QT is simply taking money out of the markets, which has an adverse effect on pricing as liquidity drives the market. I’ll let the charts below speak for themselves.
In the chart below, notice the first sell off, the beginning of the pain felt from QT. When QT is happening there is less money in the market, thus less liquidity. Simple as that.
As you can see when QT really began to take effect in late 2017, early 2018 we saw U.S. equity indices take a major hit of more than 10% in less than two weeks.
As visible in the chart, equities have struggled and we are in the midst of the distribution phase, where professionals (smart money) begin to exit and retail (dumb money) begin to enter.
After the Q4 2018 dump, the FED began talks of halting rising rates along with the normalization of the balance sheet. By normalization they are referring to getting the FED balance sheet back down to pre-GFC levels in the neighborhood of $800 billion. This next chart shows you why they can’t do that otherwise, they will have deflation, which will hurt debt payments. It’s easy to pay off debt when you can inflate your money supply, not so easy when you tighten that supply up.
As you can see, since the GFC, the World Stock Market Capitalization has been strongly tied to the rise of the four major central banks: the FED, European Central Bank (ECB), Bank of Japan (BoJ), & the People’s Bank of China (PBoC). There is no denying this now, that the global economy would’ve went no where without all this debt added to the system. And now as central banks try to normalize, they realize they are stuck between a rock and a hard place. As clearly seen when the FED began to tighten, the markets did not like that along with the rise in interest rates, most notably the fed funds rate (the rate at which banks lend each other) which went from 25 basis points (bps) (0.25% ) to 250 bps in the span of three years.
Interest Rates
Since the Q4 2018 market slide, the FED has taken a much more dovish stance and has held back on rate hikes, with the possibility of one now in 2019. Originally there were supposed to be at least a few to get rates normalized and back to more historical levels. In 2018 we saw four rate hikes, bringing up the fed funds rate substantially. The image below gives you a good perspective on the fed funds rate over the past 70 years roughly.
The FED lowers the fed funds rate by taking securities out of one the twelve FED member banks and replacing it with credit, which is the equivalent of cash. The FED does the opposite when it wants to raise rates, it adds securities to banks reserves and removes credit. Now banks will have to borrow more to meet overnight requirements. If enough banks are borrowing, then those lending will raise the rate due to increase in demand of funds that are necessary to meet reserve requirement. By giving banks these extra reserves, it allows them to lend out to meet the reserve requirements. Thus banks will lend out the excess reserves to other banks who are short of their requirement at a lower rate so they can get rid of excess reserves. The arm of the FED that handles interest rates is known as the Federal Open Market Committee (FOMC). The FOMC sets fed funds target rates during it’s regularly scheduled meetings by reviewing economic data.
Share Buybacks
Here’s a fact many do not know, share buybacks were illegal until 1982, which also coincides with the millennial boom. Share buybacks allow corporations to buyback shares and remove them from the outstanding shares. This reduces the float, which thus increases demand via decreasing supply. Instead of companies spending billions on research & development, employee raises, training, dividends, etc., they buyback shares because in the short-term it improves their stock performance, making executives and directors look good and making investors happy about share price increase.
As you can see, to some effect share buybacks really do have an effect on the market and when you look at the data of who’s buying shares, it gets real ugly. Recently Bloomberg penned an article titled: Goldman Considers ‘A World Without Buybacks.’ It Looks Ominous.
Once you see the stats of who’s really buying all the shares, you realize how broken are markets are. And then it makes sense how U.S. equities have had an amazing run since the 2009 bottom that has been fueled by cheap debt that companies use to buyback shares instead investing in themselves or their employees.
The numbers above are staggering, corporations by far are the largest source of equity demand. It’s not even close.Every other category has at least one year where net demand is negative (noted by the parentheses) except for corporations. And 2018 capped off the largest year of buybacks with over $1.1 trillion, surpassing the previous high set in 2007 that was right around $1.1 trillion. Buybacks tend to peak at market tops and as we saw in 2007, a year later most companies who repurchased shares got chopped in half if not worse.
Another issue many don’t consider is that corporations buying back their own shares are price insensitive buyers. This means they really don’t care about the price they buyback at and generally are a giant bid to absorb selling.
What’s even worse, is buybacks are off to record pace so far in 2019. 60 companies in the Russell 3000 announced buybacks totaling $106 billion in January. Companies will continue to buyback shares at record highs and soon will have to explain to investors and employees why they bought all these shares at sky high prices. Another fun thing to note is share issuance peak at market bottoms and buybacks peak at market tops. I hope you see the conundrum here. In the chart below you can see issuance makes a huge comeback at the 2002–2003 market bottom and the 2009 market bottom. Then you see buybacks peak in 2007 and same can be said with 2017.
In the end, central banks can keep pumping liquidity and suppress interest rates to make markets appear risk free, but the harsh reality will set in sooner than later. It’s not a question of if, it’s a question of when will this market collapse. On top of this you have an ever going issue of pensions, endowments, and the general public loaded up on stocks more so than ever due to yield chasing which is a by product of the low and negative interest rates we’ve seen the past decade. Combine that with the largest generation of American’s in the process of retiring or nearing retirement, baby boomers, and you have your recipe for disaster. Price discovery is broken and this will cause for a violent selloff once things begin to tumble. The fundamentals are much worse now in April 2019 than they were in the beginning of October 2018. The IMF continues to cut global growth forecasts and with geopolitical risk rising, we are likely to see market shocks. France is a perfect example, where production has slowed down heavily due to over five months of “yellow vest” protests. We will soon see how the last decade really wasn’t a recovery and when shit hits the proverbial fan it will be more apparent than ever, especially when 69% of Americans have less than $1,000 in total savings.
The pain from the coming collapse is going to be worse than 2008 and will most likely be comparable to The Great Depression. We are on the verge of systemic breakdown of our financial system. Our way of life as American’s is going to drastically change in the next decade. Manipulation has consequences.
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Disclaimer: The views expressed in this articlxe are solely the author or analysts and do not represent the opinions of the author on whether to to buy, sell or hold shares of a particular cryptocurrency, cryptographic asset, stock or other investment vehicle. Individuals should understand the risks of trading and investing and consider consulting with a professional. Various factors can influence the opinion of the analyst as well as the cited material. Investors should conduct their own research independent of this article before purchasing any assets. Past performance is no guarantee of future price appreciation.
